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Is Gold in a Bubble ?
June 01st, 2010
By James Turk owner of Gold Money

Gold has been climbing all decade long, but throughout its ascent, it wasn't until earlier this year that I first heard gold's remarkable performance described as a "bubble". Financier George Soros used that term in a seemingly disparaging way, but interestingly, we subsequently found out that he actually owned gold and expected it to climb higher.

Then last week in The Wall Street Journal, Brent Arends asked whether gold is "the next bubble?" I have now seen the "bubble" term used a third time. In an article in this week's Barron's, the author states: "The gold bubble could continue to inflate."

Anyone can read about bubbles in financial history, but there is no need to go to the library to learn about them. We have all witnessed firsthand the Internet bubble and more recently, the real estate bubble. From these events we know that bubbles are characterized by the persistent and often rapid rise in the price of an asset, which is generally fueled by speculation springing from the widespread and growing belief that the asset's price will continue to rise. But there is also another important but less well recognized feature that identifies a bubble. Namely, the asset's price eventually must rise to a point generally far above the asset's value. When that peak of overvaluation is reached, the price then falls rapidly - and typically violently like a bursting bubble.

Is that outcome about to happen with gold? No, for the simple reason that one of the principal ingredients of a bubble is missing today. Though the gold price has risen four-fold this decade, importantly, the gold price is not above gold's value, let alone far above it, which is one of the necessary ingredients of a bubble.

The articles referred to above are looking only at gold's price. What they are missing is gold's value.

Though price and value are often used interchangeably when conveying one's view on the economic merit of an asset, they mean different things. Price is the label that we give an asset when we interact in the marketplace. Value arises from each person's own subjective view of the asset's usefulness, and it is here where most people fail to understand gold. They fail to understand the source of gold's value. Gold's usefulness arises principally from two key attributes.

First, it is useful in economic calculation. In other words, gold provides an effective means to calculate the price of goods and services over time, and economic calculation is the principal function of any money. To provide but one example, the price of a barrel of crude oil today is about 2.0 goldgrams, which allowing for some relatively minor and not long-lasting fluctuations is the same price crude oil has been at anytime over the last fifty years.

Second, because it is a tangible asset, gold does not have counterparty risk. When you own gold, you own money that is not dependent upon the promise of central bankers or politicians. Gold and silver are the only monies that are tangible assets. In today's uncertain world where sovereign debts and other financial promises are becoming increasingly doubted, the avoidance of counterparty risk is an important wealth preservation objective that is likely to become even more appreciated in the months and years ahead. The precarious state of government finances generally throughout the world as well as their unending, irresponsible reliance on debt means that the value of government paper and in turn the solvency of banks that own this paper will be increasingly questioned.

Having a sound understanding of the difference between an asset's price and its value is critically important. Here's a good example where price and value were confused.

In 1983 the Dow Jones Industrial Average rose above 1000 to make a new all-time high. The DJIA kept rising into 1984, and I remember the time very well. People everywhere were stating that the market could not sustain its pace, advising instead that the DJIA was due for a correction that would put it back below 1000, the price that had capped this venerable average for nearly two decades.

We all of course know what happened. The stock market continued to soar, with the DJIA trebling over the next three years. The DJIA bears back then missed the boat because they focused on the DJIA's price. They ignored to their peril that over time the DJIA had become significantly undervalued. So the message here for gold is clear.

If you want to keep your liquidity in a tangible asset that preserves purchasing power over long periods of time and do so without counterparty risk, then continue to hold gold until it becomes overvalued. That moment is still a long way off. But how will we know when that moment of overvaluation has arrived?

The answer is simple - by looking at gold's relative value. I'll be writing more about gold's relative value in the future, but in the meantime, here is a simple catchphrase to keep in mind.

People often ask me when they should sell their gold. Clearly, they are looking back to the January 1980 peak with the benefit of hindsight. I tell them that this time around, you won't sell your gold - you will spend it. When gold is once again widely accepted as currency, which is the long-term objective GoldMoney aims to achieve, you will spend gold to purchase consumer goods to fulfil your needs and wants as well as spend your gold to purchase investments.

In other words, when gold returns to its rightful role at the centre of global commerce - which is the role it held for thousands of years up until the last several decades - then gold's purchasing power will be at its maximum.